A broker-dealer is used by two parties to transact in financial instruments on over-the-counter, or OTC, markets, which are decentralized financial marketplaces. Unlisted equities are some of the items traded in the over-the-counter market. Unlisted businesses are open to the public and are still able to sell their stock, but they cannot do so through a stock exchange like Nasdaq or the New York Stock Exchange.
Risks of OTC Trading
According to Randy Frederick, managing director of trading and derivatives at the Schwab Center for Financial Research in Austin, Texas, “the OTC market is just a lower-tier marketplace for smaller companies that trade less frequently, make less money, their prices are lower, their volumes are typically lower. While it might seem risky, some investors see the advantage in the potential of being able to get first dibs on undiscovered gems”
Consider a situation where a small business wishes to sell its shares but is unable to do so because it does not meet the requirements of exchange, such as reaching a minimum share price or having a specific number of shareholders.
The company may also not be able to afford or choose not to pay the listing fees charged by significant exchanges. In any scenario, the business could opt to sell its stock over the counter (OTC), in which case it would be doing so as “unlisted stock” or OTC securities. Essentially, it involves selling shares that aren’t traded on a significant stock exchange.
Broker-dealers can trade OTC securities through alternative trading systems like the OTC Markets Group, which publishes prices for OTC securities through a tiered electronic system.
The three tiers of the OTC Markets Group include:
Similar to security exchanges, the OTC Markets Group has criteria that securities must follow to be listed on its platform. Companies must submit specific financial data and disclosures must be up-to-date to be listed on the Best Market or the Venture Market, for instance.
Now let us examine the operation of these stages and the associated risk at each. The OTC market’s upper echelon is relatively secure, and prospects are favorable. The criteria state that a corporation must have enough information available to be considered reasonably safe.
Whenever you reach the lowest level, the pink sheets, there is a lot of danger since not only is the stock possibly as cheap as a penny stock but also because there are very few transparencies and reporting obligations. At the very base of the pink sheet market, there is a chance that fraud may exist. Investors can use this tiered market as a benchmark or a reference to determine how much risk they are incurring.
A certified financial advisor based in Dallas, purchasing OTC assets is quite simple because they trade similarly to most other stocks.
Do your research, choose a broker who supports OTC trading, and then learn more about the sector or security you’re interested in.
Find the security’s ticker symbol. If you are unable to locate the information you need, get in touch with your broker immediately. Due to the higher level of risk involved with OTC securities, as a buyer and seller of OTC securities, you might need to receive an additional level of authorization before trading from your broker-dealer.
Set a budget for your possible investment. Investors that are at ease with risk and/or interested in diversifying their portfolios through access to international markets should use OTC markets.
Through a broker, purchase your OTC security. Due to the risk of lesser liquidity and greater spreads, think about placing a limit order. The market may have fewer shares available to buy or sell due to lower liquidity, making it more challenging to trade the asset. The price differential between the highest offered purchase price (bid) and the lowest offered sale price is bigger when the spread is wider (ask). The trader has more influence over the execution price when they place a limit order.
Exchanges and OTC markets differ primarily in that exchanges are centralized, publicly listed stock prices, and are subject to regulatory control. OTC markets are less regulated, decentralized networks of trading relationships centered on broker-dealers. OTC marketplaces are therefore potentially riskier and more vulnerable to deception.
The price of assets is determined by supply and demand on an exchange, which is another significant distinction between the two. Fewer transparency results from the broker-dealer setting the security’s price in OTC marketplaces.
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